Ben Aris in Tbilisi -

The war with Russia meant that Georgia was already in crisis mode almost six months before the global meltdown struck. More importantly, the government had already received pledges of some $4.5bn in war damage aid, which turned out to be a very timely stimulus package.

The donor cash came at exactly the right time and will largely compensate for the disappearance of foreign direct investment (FDI) that had been fuelling the small Caucasus republic's tumultuous growth in recent years. Even so, GDP fell 5% in the first quarter of this year, which was worse than the government was expecting, but not as bad as the country's immediate neighbours. Remittances from Georgians working abroad - an important source of hard currency - were down to only $61m in May, but what has done the real damage was a halving of the FDI expected this year to about $1.1bn. "Our pain is less than other countries, but it is still painful," says Kakha Bendukidze, the architect of Georgia's reform process. "The key is to get back the investment and that is hard, but not too hard. We have to keep doing what we are doing now: cutting taxes and red tape."

However, the shortfall in FDI is almost entirely covered by the $1.7bn the country has already received from donors at the Brussels Donor conference, which met last autumn in the aftermath of the five-day war with Russia. Prime Minister Nika Gilauri told bne that of the $4.5bn promised, $1.7bn has already arrived; another $1.8bn will arrive by the end of the summer; and the rest is expected by the end of the year.

Of the donor money, the most useful was a US grant made in the autumn of 2008 to cover a post-war budget shortfall, which was immediately used to prop up the bank sector as well as launch a road infrastructure project, the beneficial effects of which were making themselves felt by June.

While the promised donor money is more than double the amount of FDI Georgia received last year, Bendukidze points out that most of the money is actually loans made at commercial rates and some of it is technical assistance, which the government has no control over. For example, the EU has promised €200m of assistance, but all this money will actually be spent by the EU on itself to pay for its own experts to work in Georgia. Bendukidze ticks off the restrictions on various deals and the bottom line is that the Georgian government has about $600m a year in cash for the next three years that it can spend.

The government is planning to spend its limited resources on a rescue plan that will on the one hand offer some support to the social sector, and on the other stimulate long-term investment. The main thrust of the implementation is to channel the spending through the banks, with some direct spending on large infrastructural projects.

On June 30, Gilauri gave out some details of the three-pronged stimulus programme. The first part will support the housing and construction sector by buying apartments for refugees from the war or building new accommodation. At the same time, subsidised loans will be made available for developers to complete half-finished projects.

The second prong calls for issuing T-bills to commercial banks to raise money that will be used to support the financial sector, tapping into the reserves of cash most banks have built up to deal with the rise in non-performing loans (NPLs). "As a result, banks will receive additional incomes in profit rates and the government will finance infrastructural projects by collected funds," Gilauri said.

Finally, the government has asked the international financial institutions for an extra $500m to support the banking sector. An agreement has already been signed with the Asian Development Bank (ADB) and the European Bank for Reconstruction and Development (EBRD) on the allocation of a short-term loan of $200m for the bank sector. At the same time, many of the regulations governing banking operations have been loosened to give banks more leeway to make money.

Banking on it

On the face of it, Georgia's bank sector looks pretty healthy. All banks in Georgia saw an outflow of deposits at the start of this year that continued through until May. Bank of Georgia saw some GEL200m ($120m) leave its accounts and the problems caused by the international crisis were aggravated by the start of mass street protest by opposition parties. However, both the country's biggest banks, the Bank of Georgia and TBC, report that in June the tide had turned and money was beginning to come back into their accounts. "In the first two quarters we saw GDP fall by over 6% then in April and May people were waiting to see how things turned out after the political demonstrations started. Thing were pretty tense," says Nick Enukidze chairman of Bank of Georgia.

The bank's head office had to close after protestors' filled Pushkin Square where the bank is located and closed down the centre of the city. A few months on and only one short stretch of street remains closed, with a dozen metal and tarpaulin "cells" scattered around occupied by even fewer protestors. "When it became clear that there will be no repeat of November 2007 [when president Mikheil Saakashvili sent in riot police to break up the demonstrations], everyone started to relax a bit," says Enukidze. "Now we are seeing the effects of the first lot of donor money that is starting to flow into the economy. When the government started to spend money we felt it in the rise in deposits in June, especially in the corporate sector. We are at, or have passed, bottom."

Part of the reason the bank sector seems so solid is that it had borrowed so little from abroad. The total external debt of the banking sector was some $600m at the end of last year, of which Bank of Georgia accounted for $240m and TBC another $100m. Both these banks managed to pay off their debts entirely by January, leaving the sector well capitalized and with plenty of liquidity. Indeed, TBC saw the crisis as an opportunity to extend its market share and has continued to open all the new branches it planned to open, although it has frozen further expansion after the current plans are completed. "The important thing was to stabilise the bank operations and we are seeing things pick up on the deposit side," says Badri Japaridze, vice president of TBC. "Where we want to push the opportunity is to grow our share of the market."

Officially, the sector's non-performing loans (NPLs) are low. The International Monetary Fund (IMF) estimates, based on the central bank's numbers, that NPLs are a mere 3.7% of the sector's total loan portfolio. However, experts worry that the true number is much higher. The trouble is that academics say Georgia's statistics are very unreliable and almost no one believes they state the true picture.

Even Georgia's mega-regulator, the Supervisory Agency of Georgia (FSA), said in June the real level of NPLs is over 15% and some experts fear that the real level could be as high as 30% - a potentially catastrophic level. While the actual number is in dispute, it is clear that the IMF's number must be too low. Georgia is unusual in the former Soviet Union in that it already has a functioning central credit agency, Credit Info, which says that the total number of bad debts has risen from 142,000 at the start of the year to 192,000 as of the middle of this year, worth GEL228m, which is about 15% of the total amount of credits. Sandro Gomiashvili, the head of Credit Info told the Georgian Journal recently that the level of bad debt is almost certainly higher, as the banks are not obliged to report on bad debt over the level of GEL100,000. And as most of the bad debts are overdue mortgages, few banks have dared call in bad housing loans with real estate prices falling. If banks tried to push through forced sales, the bottom would drop out of the market.

Against these worries, the leading banks are all reporting manageable NLP levels. The official results of the leading banks are also low: Bank of Georgia reports at most 4.7%; Basis Bank 2-3%; German-owned ProCredit bank 1.26%; and while leading banks TBC and Bank Republic (owned by Societe General) have not released their numbers, both said the level of their bad debt is modest. "The quality of the loan books is deteriorating especially in retail segment, but the numbers are still in single digits. The rise in NPLs is typical for an economy under pressure but we are still nowhere near crisis levels," says Enukidze. "Russia, Ukraine and Kazakhstan were all three years ahead of us. We had one year of very aggressive retail lending. If we had started this three years ago then we would have the same problems as these big countries do now."

Still, the crisis has shaken the sector up. HSBC's Georgian subsidiary announced at the end of June it was exiting from the retail sector altogether to concentrate on corporate banking and gave its clients 60 days to close their accounts. And the government has committed GEL20m to a subsidised credit programme to try and get the wheels of commerce moving again.

Real economy

The real economy is where the real problems lie. Gilauri likes to boast that Georgia isn't famous for anything in particular, as its economy is so diversified it does a little of everything. Certainly, the government can be proud of its success with economic diversification, but because the country is so small, it remains very dependent on the surrounding countries for trade and investment; if the region is feeling the pain of the crisis, then so will Georgia.

Georgia's companies were slow to respond to the crisis. Nadia Turnava, a former deputy economy minister and now CEO of Georgian Industrial Group, one of the biggest holdings in the country, says that industry continued to produce during the first months of this year, but industrial production has since gone into a tailspin. For example, the country's pharmaceutical firms have suspended exports completely, while Georgia's largest fertilizer plant Azot closed the factory due to lack of demand. "The top-10 biggest companies in Georgia have almost all reduced their activity and some have stopped production altogether. In January and February, things didn't look too bad, but companies were producing and storing their products. In April and May, the storage was full and they needed to sell inventory, but there are no buyers or prices are still very low," says Turnava.

The government is betting its money on a big infrastructural spending programme. The banks report that the effect of spending on road building programmes is already having a positive effect, but amongst the biggest programmes is a plan to build a 500-kilovolt power line across the country that would allow Georgia to sell its copious hydropower to Turkey.

The privatisation of the country's utilities is already finished (apart from one big hydropower plant that is shared with the breakaway region of Abkhazia), but earlier this year the government issued a list of 80 sites on which new hydropower facilities can be built. The idea is that the new power line will both earn revenue and at the same time entice Turkish investors in to build some new power stations in the east of the country. Turnava remains sceptical: "This is the third time the government has launched plans to build this power line, so we will wait and see."

The bottom line is that thanks to the donor money, Georgia will be okay for the meantime, but the risk is that it will either run out of money before the recovery starts in earnest or it will spend the money badly and things will continue to get worse. Bendukidze says the government's choices are limited: "America can leverage international money supply and spend its way out of the crisis, but for a small country like ours, there are only three instruments available: reduce taxes, cut red tape, and aggressively pursue foreign investment by knocking on a lot of doors."

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